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MONEY
Functions of Money
Money is something which people generally accept in exchange for a good or a service.
Money performs four main functions:

a medium of exchange for buying goods and services;

a unit of account for placing a value on goods and services;

a store of value when saving;

a standard for deferred payment when calculating loans.
Properties or Characteristics of Money
Any item which is going to serve as money must be:

acceptable to people as payment;

scarce and in controlled supply

stable and able to keep its value

divisible without any loss of value

portable and not too heavy to carry.
Gresham’s Law- ‘ bad money drives out good money’
If there are two types of money, and one is more valuable than the other , the inferior
money gets used/ circulated and it drives the valuable / superior money out of
circulation. People will hoard the good money and spend it.
MONEY SUPPLY
Definition
The money supply is the total amount of assets in circulation, which are acceptable in
exchange for goods. In modern economies people accept either notes and coins or an
increase in their current account as payment. Hence the money supply is made up of cash
and bank deposits.
Credit Creation
Some customers leave money in the bank earning interest. A bank can use these idle
deposits to make loans to people who then buy goods. Shopkeepers receive extra money,
which they redeposit with the bank. Some of this redeposited money is left to earn
interest and can be re-lent. The bank has therefore created money. If all customers were
to try to cash their deposits at once, there would not be sufficient cash. The amount of
money the bank can create therefore depends on the ratio of cash to liabilities that they
hold. The higher this cash ratio the less money the bank can re-lend or create.
How do banks create money?

Assume a single bank, Barclays bank

Mr. Moyo deposits $20000 cash in the bank.

By depositing $20000 in the bank, money changes its form from cash to deposit.

Mrs. Maphosa wants to borrow money for business.

Barclays Bank can lend because it knows Mr. Moyo will not withdraw all at once.
But it knows it must keep some cash as a reserve say 10% therefore Barclays
lends $18000 to Mrs. Maphosa.

By lending money to Mrs. Maphosa, the bank increases money supply to $38000
from just $20000. The bank is able to create money because people have
confidence that the cheques signed by the bank are honoured.
If the reserve ratio is r then the basic definition of money multiplier (m) 
The change in total deposits (AD) =( 1/r x Deposit)
When r = 0.1 and deposit = 20000, then
The change in total deposits = D=
D 
1
1
 Deposit 
 20000  200000
r
0.1
1
r
From this calculation changes in deposits can be as high as $200000 from an initial
deposit of $20000. If the reserve ratio increases, it limits the change in deposits
because most of the deposits are kept as reserves and not lent.

Limits to banks to create money will depend on:

Amount of reserves (liquid) assets

Reserve asset ratio

Willingness of people to borrow

Desire of people to hold cash.

What is regarded as reserve asset must be defined by law. The following assets
can however be regarded as reserve assets:

Cash balance with central bank

Foreign exchange

Treasury bills

Gold etc.
Definitions of money
1.
M
0
 B  Monetary base = currency and reserves. It is also called high powered
money.
2. M1  currency and Demand deposits M1  notes and coins in circulation with
public. It is sometimes referred to as ‘narrow money’
3. M 2  M1  Savings deposits with banks. It is sometimes referred to as broad money.
4. M 3  M 2  Other savings deposits etc.
Determining Money Supply
1. r 
R
D
2. C 
c
D
Where r - reserve ratio
R - Reserve assets
D - Demand deposits
C - Currency ratio
c - Notes and coins in circulation
in countries like Zimbabwe, the currency ratio is very high because many people keep
notes and coins at home. This is because the banking system can at times be
inconvenient.
3.
M
M
s
cD
s
 CD  D
M
s

M
1
 1  C D
B cR
4. B  CD  rD
D 
M
s
s
B
C  r 
 1  C D

M
B  Monetary base
1  C  B
C  r 
Where m 
 mB
1 C
Cr
-
m is the money multiplier and is greater than 1 (m>1)
-
the reserve ratio can be separated into required reserve ratio
reserve ratio
r 
s
r  rr  rs
- Banks hold excess reserve ratio because
r 
r
and excess
1. Most banks are prudent (prudential banks ) and sensible to see whether lending is
profitable.
2. Limited liability of banks to create
M
1
since people may not be willing to
borrow due to high interest rates.
M
s

1 C
B
C  rr  rs
 mB
DEMAND FOR MONEY
-
M
-
D
refers to the amount of money held by the general public in an economy.
The main reasons for holding money are:
1. Transactional reason/ motive
2. Speculative motive
3. Precautionary motive.
MONETARY POLICY
What is Monetary Policy?
It is the use of money or its cost, the interest rate to fine tune some economic variables
such as :

Inflation

Economic growth

Investment

Interest rates

Balance of payments
Objective of monetary policy
In general monetary policy has two major objectives:
1. To reduce inflation (stability objective)
2. To boost economic growth (growth objective)
Instruments / Measures/tools of monetary policy

Monetary policy measures are used to increase or decrease the amount of
money, depending on the situation prevailing.

Each instrument can be used in 2ways, either to increase or decrease the
amount of money in circulation
The following are some of common instruments:
1. Bank rate
2. Open market operations
3. Rediscount rate
4. Repurchase Agreement
5. Selective credit controls
6. Moral Suasion
7. Reserve requirements
These instruments can be classified into the general or quantitative instruments and the
selective or qualitative instruments.
General or quantitative instruments
These include open market operations, changes in the minimum legal cash reserve ratio
and changes in the bank or discount rate. These instruments influence the credit creating
capacity of the commercial banks in the economy by operating directly or indirectly on
their excess cash reserves.
Selective or qualitative instruments
The instruments affect the types of credit extended by the banks. They affect the
composition rather than the size of the loan portfolios of the commercial banks. The
immediate object of imposing the selective credit controls is to regulate both the amount
and the terms on which credit is extended by the banks for selected purposes. The
selective credit control instruments enable the central bank to restrict unhealthy
expansion of credit for specific purposes; without at the same time airing credit
expansion in general.
Use of the Instruments/ Measures /Tools
The instruments are contractionary or expansionary, depending on the liquidity situation.
When there is too much money, monetary tools are used in contractionary way. When
there is less money, monetary tools are used in an expansionary way.
Bank Rate/ Rediscount Rate
When banks borrow from the Central Bank directly, they are charged a bank rate.
When they borrow indirectly through the discount houses, they are charged rediscount
rates.

This is the rate at which the central bank discounts first class bills.

It is a benchmark for commercial bank lending rates.

An increase in the bank rate increases lending rates and reduces the amount of
money.

A decrease in the bank rate reduces lending rates and increases the amount of
money.
Open market operations
This is buying and selling of government securities e.g. bonds (TBs). When there is too
much money, the government sells securities. The government takes the money and the
public holds securities. To reduce money supply, the government sells bonds to the
public and pays with currency (notes + coins in circulation). This reduces money
available for spending. The success of the instrument depends on whether the public
wants to buy bonds or not. To persuade people to buy bonds, the government raises
interest.
When there is inadequate money, the government buys securities. The government takes
the securities and the public holds money. Money is injected into the economy.
Selective credit controls
When there are liquidity problems, the central bank and even banks have preferential
treatment of clients. Credit is allocated to some selected sectors. For example, credit can
be allocated to export or productive sectors. Rationing of credit- this involves imposing a
ceiling upon its (Central Bank’s) discounts for any one bank or rejecting a proportion of
each discount application whenever total demand for loans exceeds the amount the
central bank is prepared to discount on any one day.
Regulation of consumer credit
The regulation of consumer credit is employed to regulate the terms and conditions under
which bank credit repayable in installments could be extended for purchasing or carrying
the consumer durable goods. The regulation of consumer credit is quite important in
combating inflation by restricting the aggregate consumer demand for those goods which
are in short supply in industrially developed countries where consumer credit is largely
used to finance domestic purchases. In countries where there is no consumer credit and
the banks do not participate in financing the purchase of consumer durables to any
significant degree, the method cannot be effective in curbing the inflationary pressures in
the economy.
Moral Suasion
It involves direct solicit with the Central Bank. The central bank persuades financial
institutions to be supportive of the prevailing monetary policy stance. When there is too
much liquidity, institutions are persuaded to tighten their credit allocation systems. When
there is a shortage of liquidity, institutions are persuaded to loosen their credit allocation
systems. This measure is not mandatory but persuasive and as a result it is difficult to
influence the currency ratio c/D and consequently money supply.
The instrument would succeed only if the commercial banks follow scrupulously the
leadership of the central bank. This will however depend on the strength of the central
bank and the prestige enjoyed by it among the member banks. In countries with highly
liquid monetary conditions and where the central bank cannot undertake open market
operations on a massive scale to counteract the high bank liquidity, it is advisable for the
central bank to use moral suasion.
Reserve Requirements
When bank deposits are made, part of the money is kept as bank reserves and the rest
is lent out as loans. The reserve requirement is the amount of money that is kept as
reserves. The percentage of money kept as reserves is called the reserve requirements
ratio. When there is too much money, the reserve ratio is increased to reduce credit
creation. When there is a shortage the reserve ratio is reduced to increase credit
creation so as to increase money supply. The government can regulate the required
reserve ratio
r . r
r
r
 m  M
s
Increasing required reserve ratio reduces the lending base. The instrument is not
without its limitations: If their cash reserves are swollen, commercial banks will not
care at all for the increase in the minimum legal cash reserves ratio requirement
unless the increase is very high. They might also conduct their operations with a
lower cash reserves ratio if they are optimistic about the future, while a fall in the
minimum legal reserves ratio may fail to induce them to lend in depression. A
counteracting force may arise from a change in the banking practices. If percentages
of minimum legal cash reserves required to be kept with reserve banks differ for
different kinds of deposits held by banks e.g. with a minimum legal cash reserves
ratio of 10% against the demand deposits and of 3% against the time deposits, a
transfer of bank funds from the former to the latter would enable the banks to expand
credit and to that extent would induce them to disregard the credit restriction policy
enforced by the central bank.
Publicity
Central banks may employ the instrument of publicity in order to publicise the economic
facts in the weekly statements of their assets and liabilities, monthly bulletins containing
review of credit and business condition, and detailed annual reports stating their
operations and activities, the state of affairs of the money market and banking system and
general review of the trade, industry, agriculture, etc. in the country. By resorting to
publicity, the central bank enlists public opinion in favour of its monetary policy and
thereby combats opposition to its policies among political, financial and business
interests. However the method of publicity has the scope of useful application in
industrially advanced countries where public opinion is enlightened. In the developing
countries where people are mostly less educated and even those who are educated are not
acquainted with the technique of banking the method of publicity is of little use in
controlling credit.